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Woodford: markets are grim but this is no 2008 re-run

Struggling banks and ‘Brexit’ fears add to global woes but 2016 is not a repeat of the financial crisis, says leading fund manager.

 

by Gavin Lumsden on Feb 25, 2016 at 13:11

Woodford: markets are grim but this is no 2008 re-run

This year is bad but cheer up, it’s not as grim as the financial crisis says fund manager Neil Woodford.

Bank shares have tumbled amid growing concern for the global economy but Neil Woodford, who consolidated his reputation as a gifted fund manager by shunning the sector before the financial crisis, is not predicting a repeat of the meltdown eight years ago.

‘I don’t think we’ll see a re-run of markets we saw in 2008,' said the Citywire AAA-rated manager. ‘I’m not a great believer in banks but they’re a lot better than they used to be.’

‘People confuse solvency [the ability to meet long-term obligations] with liquidity [having enough cash to settle customer transactions] – that’s what takes banks down,’ he said, adding that the Bank of England was now much better at avoiding the problems that brought down Northern Rock, Royal Bank of Scotland and HBOS-Lloyds TSB.

However, he was less confident about banks in Europe and China.

‘The European banking systems is sick,’ said the manager of the £8 billion Woodford Equity Income fund who argued not enough had been done to tackle bad debts in Europe’s banks. Now they were weak at a point when the world economy was slowing, which made him worry about the fragility of Europe’s recovery.

‘[Mario] Draghi [president of the European Central Bank] said he’d do whatever it takes and everyone forgot the debt burdens and headwinds,’ said Woodford, who pointed out Italy’s debts were 30% bigger than its economy and that France’s debt burden was growing to dangerous levels.

The situation was even worse in China, which he compared to ‘an engine going into reverse’.

‘China embarked on a credit bubble and that’s bursting right here and now,’ he said, predicting: ‘The Chinese government will have to recapitalise its banks and deal with the legacy for many years.’

‘The years ahead for China are going to be very difficult,’ he added.

That had implications for everyone, he told journalists at a briefing organised by his company Woodford Investment Management on Tuesday. ‘The things to worry economically are not inflation and growth acceleration, they’re deflation and growth deceleration.’

That wasn’t the same as a recession, he said, as the world would grow, just not by very much.

No more rate hikes

According to Woodford that ruled out further rises in US interest rates. The stock market reaction since the Federal Reserve raised interest rates in December for the first time in seven years showed it had been a policy mistake, as he had predicted it would be, he said.

It also made a hike in the UK virtually impossible. ‘The notion of higher interest rates [in the UK] makes me laugh, frankly,’ he said.

‘Stand by for more extraordinary monetary action,’ from central banks, he predicted, which having tried quantitative easing (QE), or ‘money printing’, had now resorted to negative interest rates in Europe, Japan and Norway.

The problem with QE, said the manager, is it had inflated the gap between asset prices and economic fundamentals. As valuations pushed up, growth in corporate earnings, or profits, had been vital to justify the increases investors were being asked to pay. With the economy slowing, however, profits at many companies were falling, their dividends were being cut and share prices were retreating.

‘The market is beginning to realise that valuations can’t be supported by earnings growth… and consequently there is more risk,’ said Woodford.

Woodford said he had seen one forecast of a 10% cut in dividends in the UK this year, which would put pressure on pensioners, pension schemes and equity income funds like his. Woodford Equity Income paid 4p per unit last year and Woodford is hopeful his big holdings in solid dividend payers like tobacco and drugs companies mean this can be rise to 4.2p this year, despite the clouds over shareholder pay-outs.

The fund’s total return since launch in June 2014 to 22 February was nearly 19%, which beat most of its main rivals and the FTSE All Share index, which fell 4.5%.
 
Whether the level of UK dividends fell or not, he said, depended on whether BP (BP), Royal Dutch Shell (RDSb) and HSBC (HSBA) – none of which his fund holds – clung on to what he called their ‘unsustainable dividends’.

With shares in the oil giants yielding over 9%, BP and Shell are under intense pressure to cut their dividends and save cash. BP cut its dividend following the Gulf of Mexico disaster in 2010 but Shell has not reduced its pay-out since the Second World War and is loath to abandon its dividend record.

'Abysmal' HSBC results

Woodford spoke about HSBC, which in 2013 was the object of a surprise move by the fund manager when he bought a small stake. Woodford then doubled the shock just over a year later by selling the bank’s shares, citing concerns over the rising cost of cleaning up the payment protection insurance scandal as the reason for changing his mind.

Shares in the Asia-focused bank have fallen 28% in the past two years in response to China’s difficulties so it was the right move.

Woodford said the stock’s current low level did not tempt him. He described the bank’s recent annual results as ‘abysmal’ showing it generated a 4% return on equity while trying to support an 8.5% dividend yield and strengthen its capital reserves.

‘Since then [the sale of the shares] I’ve become more bearish about China and become more concerned about Asia and their ability to achieve an attractive return given deflation.’

And he added the negative interest rates and money printing by central banks was harmful as well: ‘The business is very challenged, not least by extraordinary monetary policy which crushes their margin.’

All of which sounds very gloomy, except Woodford has not stuck a big wedge of the Equity Income fund in cash, a classic sign of a truly bearish fund manager.

‘The economic and financial market future is challenging,’ he said. ‘But I’m fully invested because I think there is a subset of the market that can grow.’

Woodford is unique among fund managers in publishing the full portfolios of both his funds every month. He believes it is important to be open with investors and that his transparency is in stark contrast to the rest of the investment industry.

'Tidal wave of innovation'

One of the remarkable aspects of the list of holdings in Woodford Equity Income is the long tail of smaller healthcare, technology and internet stocks you see once you get past the top 15 of large dividend payers, such as the now-renamed Imperial Tobacco business Imperial Brands (IMB), British American Tobacco (BATS), AstraZeneca (AZN), Roche (ROG.VX) and Legal & General (LGEN).

Holdings in companies such as Stratified Medical, Imperial Innovations (IVO), Ratesetter and Purplebricks (PURP) show his wide-ranging and long-standing interest in the commercialisation of British scientific research and start-ups that use the internet to disrupt traditional businesses such as lending and home selling.

It also shows the influence of his other fund, the £730 million Woodford Patient Capital Trust (WPCT ), which, although it has suffered a tough start since its launch last March, has focused on early stage companies both on and off the stock market.

‘One of the great privileges of investing in early stage companies is the great insight it gives us,’ said Woodford who sounded a bit like the other perennial investment bulls, Nick Train and James Anderson, when he said: ‘What we see coming down the pipe is a tidal wave of innovation that will transform our lives for the better.’

Although humanity hadn’t addressed the problems of hunger, disease, climate change and ‘the energy conundrum’ of relying on carbon fuels that harm the environment, he remains optimistic. ‘I see the early stage companies addressing these fundamental issues,’ he said.

Calm over Brexit storm

But before Britons get to a Brave New World, there is the little matter of the referendum of the UK’s membership of the European Union on 23 June. This is making volatile markets even more turbulent as investors debate the pros and cons of a potential ‘Brexit’ from the EU.

Woodford Investment Management intervened in the debate last week by publishing a report from Capital Economics which highlighted the risks to the City of London of a UK withdrawal but downplayed the broader significance to the UK economy.

Woodford said the vote was about other ‘visceral’ issues such as sovereignty and immigration, rather than the economy, and claimed he was ‘undecided’ over how to vote.

He criticised the bosses of FTSE 100 who signed a letter this week urging the UK to vote ‘yes’ to the EU on economic grounds: ‘I think they’re wrong – I think it lacks credibility.’

‘Too many people in the UK are thinking too narrowly about the issue,’ he said. ‘You’ve got to think about it in a pan-European way. If the UK left there would be a profound change in the way the EU worked.’

Warming to his theme he added: ‘It’s more important for the EU than the UK. The EU is in a pretty troubled place. The immigration crisis is challenging the pillars that stand behind the EU: the free movement of capital, free movement of labour and goods and services, although we’re not there yet.’

The pound has fallen amid the uncertainty, but Woodford said so would the euro after a Brexit as the market would begin to worry about the sustainability of the euro project. The US dollar would likely benefit, he said.

Neither scenario alarms him. ‘It’s highly unlikely that sterling will be seen as a basket case versus emerging markets and the fears of debt burden and solvency and concerns about China more broadly.’

Besides, he said: ‘A strong dollar, weak sterling is good for my portfolio and I would welcome it.’

5 comments so far. Why not have your say?

colin overton

Feb 25, 2016 at 16:42

Interesting points. From the first item, if Euroland banks and economies are so over borrowed an Out vote in June would at least partially isolate us from any Euro-borrow, unless DG chucks in another 20-30 billion of extra UK borrowing. From the last item we are told that The City of London might suffer from a Brexit, but they'll be owned by Germans, so what the who?

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S_M

Feb 25, 2016 at 17:05

Colin owning the LSE doesn't constitute a German takeover of the city!

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Anonymous 1 needed this 'off the record'

Feb 25, 2016 at 18:21

As usual, NW talks oodles of common sense. No surprise he has been so successful.

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normski 2nd

Feb 26, 2016 at 14:04

Very interesting piece, I like it.

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Thrugelmir

Feb 28, 2016 at 17:25

Food for thought.

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